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The Commission Communication on the treatment of impaired assets

On 25 February 2009, the European Commission (the Commission) published a Communication concerning the treatment of impaired assets in the Community banking sector1. This supplements its Banking Communication of 13 October 20082 and its Communication on the recapitalisation of banks dated 5 December 20083, and provides guidance on how member states can create state aid schemes for impaired assets in conformity with EU rules. It also sets out the requirements these rules must fulfil to gain state aid approval.

The Commission considers a common and co-ordinated community approach necessary to ensure a level playing field within the single market. The Commission intends to align the objectives of safeguarding financial stability and underpinning bank lending with the need to avoid longer-term damage to the banking sector within the Community.

The Communication covers both the purchase of impaired assets by the state (for example, bad bank scenarios) as well as insurance solutions, guarantees or, where necessary, the nationalisation of banks. Within the scope of the framework provided by the Communication, member states should retain sufficient flexibility to allow them to tailor measures for individual banks. The precise form of the relief measures will therefore remain the responsibility of each member state, as long as a functional and organisational separation of the impaired assets of the bank and its customers is ensured. Therefore, each member state is free to decide upon the use of a specific form of relief measure or even a hybrid form. However, all rules should be assessed from a state aid law perspective according to uniform criteria.

In its Communication, the Commission addresses the following issues in particular:

eligibility of assets;

methods of valuation and pricing of assets eligible for relief;

further definition of the state aid rules and relief

award procedure – in particular transparency and disclosure requirements, as well as incentives to participate; and

follow-up measures.

Criteria for state aid schemes

Member states’ state aid schemes must fulfil certain requirements set out in the Commission’s Communication to be eligible for approval under state aid law. Asset relief measures constitute state aid inasmuch as they free the beneficiary bank from the need to either register a loss or to build up a reserve for a possible loss. In addition, asset relief measures can free regulatory capital for other uses.

Identification of the assets captured by the relief measure

The Commission proposes a common and co-ordinated Community approach to the identification of impaired assets eligible for relief measures. This is intended to prevent distortions of competition and arbitrage. According to the Commission’s concept, consistent categories of assets (baskets) that reflect the extent of existing impairment should be developed. The use of these categories would facilitate the comparison of banks and their risk profiles across the Community. Member states would then need to decide which category of assets should be covered by their measures and to what extent.

However, each member state will be able to extend its programme, upon due justification, to other well-defined categories of impaired assets without quantitative restrictions, in order to eliminate risks threatening the stability of the financial market.

Furthermore, member states may apply their relief mechanisms to impaired assets outside the scope of the categories set out above, without the necessity of a specific justification, for a maximum of 10 to 20 per cent of the overall assets of a given bank covered by a relief mechanism. This is to allow for the diversity of circumstances in different member states.

In any case, the Commission will not consider assets eligible for relief measures where they have entered the balance sheet of the beneficiary bank after a specified cut-off date prior to the announcement of the relief programme. With the provision of a uniform and objective cut-off date a level playing field among banks and member states will be ensured. The Commission refers to the end of 2008, for example. Valuation of assets eligible for relief and pricing

Valuation process

In the Commission’s view, the ex ante valuation of impaired assets should be based on a uniform methodology established at Community level. As a first stage, assets should be valued on the basis of their current market value, which, for certain impaired assets, may be as low as zero. In general, any transfer of assets covered by a scheme at a price in excess of the market price will constitute state aid in the amount of the difference. As a second stage, the value attributed to impaired assets in the context of an asset relief program (a purchase, insurance or guarantee), the so-called ‘transfer value’, will inevitably be above current market prices in order to achieve the relief effect. The Commission considers a transfer value reflecting the ‘real economic value’ as an acceptable benchmark indication. This ‘real economic value’ is to be calculated on the basis of available market information and both realistic and precautious assumptions on future cashflows. The more this transfer value exceeds the ‘real economic value’, the greater the need for compensation and restructuring measures.

With this methodology, the Commission offers only guidelines to member states. In any case, the valuation process applied by a member state has to comply with generally acknowledged international standards. The Commission will assess the valuation methods put forward by member states and for this purpose will consult with expert panels.

Where a valuation is rendered impossible because of its complexity, alternative approaches may be considered. For example, the creation of a ‘good bank’ may be achieved whereby the state purchases good assets rather than the impaired assets. An alternative option may be nationalisation, with a view to carrying out the valuation over time in the context of a restructuring or an orderly winding-up of the bank.

Alternative structures that avoid a valuation of the assets being transferred, eg a transfer by means of a spin-off as discussed in Germany, would be assessed according to the same state aid rules. In this case, the Commission would also require a valuation of the assets.

Remuneration of the state aid

A further requirement is the adequate remuneration of the relief measure. The remuneration must adequately take account of the risks of future losses exceeding those that are projected in the determination of the ‘real economic value’. Remuneration may be provided by setting the transfer price of assets at below their ‘real economic value’ to a sufficient extent, with regard to the risk incurred, or by adapting the guarantee fee accordingly.

In view of the identification of the necessary target return, the Commission refers to the Commission Communication on the recapitalisation of banks as source of ‘inspiration’. However, the specific features of asset relief measures must be taken into account. The Commission proposes that, in a first step, the capital effect of the proposed asset relief could be regarded as a capital measure of the same amount and be remunerated according to the Communication on the recapitalisation of banks. In a second step, the amount of the remuneration must be adjusted with regard to the higher risk exposure of asset relief measures and, in the case of an asset guarantee or insurance solution, with regard to the fact that no liquidity is provided. The pricing system could also include warrants for shares in the banks equal in value to the value of the assets.

If an ex ante remuneration is not possible, a participation of the bank in future losses can be achieved by means of clawback clauses. Also, a subsequent increase of the remuneration can be achieved by means of betterfortune clauses.

Further characteristics of national asset relief schemes

With regard to the further design of the state aid schemes and procedures, three aspects of the Communication are particularly noteworthy:

full disclosure and transparency ?? of impairments and viability assessment;

time limitation of the relief programme and provision of incentives to participate; and

imposition of behavioural constraints.

According to the Communication, any relief measure must be based on a clear identification of the magnitude of the bank’s asset-related problems. The qualification for state aid must therefore depend on the full transparency and disclosure of the impairments to be covered by the measure. The amount of the state aid and the losses incurred by the bank through the transfer can be ascertained with reference to the appropriate valuation methods mentioned above.

Subsequently, a review of the business model and the balance sheet of the concerned bank must be undertaken to assess its capitalisation and long-term viability. The results of this assessment must be disclosed to the Commission and will form the basis of the decision on the necessary follow-up measures.

The burden sharing between the bank and the state should, as a general principle, be designed in a way that the banks ought to bear the losses associated with impaired assets to the maximum extent. This should be achieved by means of a correct ex ante valuation of the impairment. If, however, an ex ante valuation cannot be realised, the burden sharing can take place ex post. For this purpose, the Commission encourages the beneficiary bank to bear the ‘first loss’ (typically with a minimum of 10 per cent) and to participate in a percentage share (typically with a minimum of 10 per cent) of any additional losses.

If the resulting loss leads to a situation of technical insolvency, the bank should be wound up in an orderly manner, or put into administration. In such situations, bondholders – but not shareholders – may be protected by the state. In cases in which a technical insolvency of a bank is not economically feasible because of the bank’s systemic importance, aid may be granted for a preliminary period, such as is necessary to allow for the development of a plan either for a restructuring or a winding-up. In addition, nationalisation options may be considered.

To limit incentives for banks to delay necessary disclosures in the hope of higher levels of relief at a later date, impaired asset relief programmes should, as a general feature, have an enrolment window limited to six months. Participation after the expiration of the six month enrolment window should be possible only as a result of exceptional and unforeseeable circumstances for which the bank is not responsible. In such cases, stricter conditions should be applied.

Member states’ individual programmes may provide for optional participation and include appropriate incentives for banks to participate. However, participation may also be mandatory. In any case, programmes should include a mandatory disclosure requirement for disclosure of the magnitude of a bank’s asset-related problems to the authorities, so that the need for and scope of an asset relief scheme at the member state level can be identified.

Access to asset relief should always be subject to a number of behavioural constraints. In particular, beneficiary banks should be subject to provisions that ensure that the capital effects of relief provide credit appropriately, to meet demand. Restrictions on dividend policy and caps on executive remuneration should also be considered. The specific design of behavioural constraints should be determined on the basis of a proportionality assessment taking into account a number of different factors.

Follow-up measures

In the Commission’s opinion, the removal of risks from a bank’s balance sheets might not in itself be sufficient to ensure the long-term viability of the beneficiary bank (ie the bank can survive without future state support). Therefore, the Commission requires a ‘viability review’ for the assessment of the viability subsequent to the asset relief. If necessary, further adequate measures must be taken in order to restore the viability (restructuring measures). In addition, it must be assessed whether measures are necessary to remedy distortions of competition (eg downsizing, behavioural constraints). The Commission will take those decisions on a case-bycase basis based on the criteria set out in the following paragraphs.

As regards the potentially necessary restructuring measures, the Commission will take, as a basis, the criteria set out in its Communication on the recapitalisation of banks. Other criteria will also influence the decision, including:

the proportion of the bank’s assets subject to relief;

the transfer price as compared with the market price;

the nature and origin of the problems of the beneficiary bank;

the soundness of the bank’s business model; and

investment strategy.

The scope of the compensatory measures will depend on the Commission’s assessment of distortions of competition resulting from the aid. Notably, the compensatory measures will be determined, inter alia, on the basis of the following factors:

total amount of aid;

volume of impaired assets benefiting from the measure;

amount of remuneration;

proportion of losses resulting from the asset;

quality of risk management of the bank; and

market position of the beneficiary bank.

In contrast to the Communication on the recapitalisation of banks, no distinction is made between fundamentally sound banks and other banks. This distinction has been abandoned as it gives rise to stigma and is difficult to apply in grey areas.

State aid notification

Member states notifying state aid must provide the Commission with comprehensive and detailed information, notably a detailed description of the valuation methodology and its intended implementation. Approval of the aid will be granted for a period of 6 months, and will be conditional on the commitment to present either a restructuring plan or a viability review for each beneficiary institution within 3 months from its accession to the asset relief programme. At this point in time, the member state must provide the Commission with detailed information on the assets covered by the relief measure and how they were valued, certified and validated by the supervisory authority. The Commission may reassess in a new decision whether the compatibility of the aid granted can be prolonged, taking into consideration the proposed restructuring and remedial measures.

Ad hoc measures

The conditions described by the Communication apply to general measures, ie state aid schemes designed for the banking sector as a whole, as well as to ad hoc measures. In the case of an ad hoc measure, a member state must also provide the Commission with detailed information regarding the assets covered by the measure, including its certified and validated valuation. This must be done, at the latest, when the restructuring plan or viability review is notified. It can be assumed that the Commission applies the same requirements for ad hoc measures (for example in relation to the amount of remuneration) as it does for member state state aid schemes.

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